After spending the past several months laying out the case against active money management, alternative investments, and excessive compensation and fees, Ive received a number of emails and phone calls challenging the themes of this column. My critics have been polite but firm in their conviction that my messages are wrong. Some will concede that my general conclusions are valid, but their ability to pick stocks or bonds, manage a hedge fund, or select exceptional money managers is a well-deserved exception to my contentions. I thought it might be helpful to lay out some of these objections, because investors need to know how to parry the well-constructed assertions of active money managers.
To begin with, money managers are an extremely confident group of people. Despite overwhelming academic and industry data to the contrary, the vast majority of money managers genuinely believe that they can beat the market and add value for their clients. Behavioral economists call this a bad case of overconfidence. I suppose, anyone who continues to actively manage money or pick money managers has to retain faith in their abilities. If that confidence were to disappear, it would be time to get into another line of work. However, most money managers know that no other profession pays as well, so their confidence may be shaken for a time but it never disappears.
Few appropriate benchmarks
So what did these overly confident managers have to say to me? Many specialists claimed that their area of focus is less efficient than large cap stocks or investment grade bonds. Thus these folks concede that the S&P 500 or Barclays Aggregate Bond Index is tough to beat, but small cap stocks or emerging market debt offer consistent opportunities to outperform. While it is true that more esoteric markets may have more mispriced securities, there isnt much evidence that those prices are systematically over or underpriced. In other words, as you move away from large companies there is less research and price discovery, but that doesnt make it any easier to add value for clients. Moreover, any opportunities in an overlooked market quickly disappear once institutions start doling out large amounts of capital to money managers to invest in those so-called inefficient markets.
Another group of critics claim that their lack of superior performance is because the benchmark doesnt properly capture their investment style. This is a great argument for the manager to make because it leads to an endless debate and encourages clients to ignore that the manager is failing to add value. In fact, this is the real beauty of hedge funds. There are few, if any, appropriate benchmarks, so its difficult to say whether most hedge funds are adding value. It is only when they occasionally melt down that one gets definitive evidence that they have failed.
Ive also heard from managers who can provide evidence that theyve consistently added value and that the average manager in their investment universe beats the benchmark. When this happens, youve probably uncovered a poorly constructed benchmark instead of an outstanding investment opportunity. Remember that money managers are masters of compiling compelling marketing material. Moreover, exemplary performance tends to disappear just about the time you screw up the courage to invest with the money manager.
So far weve examined critics who have contested my basic premise about the ability of active managers to add value. Theres yet another group, which accepts my premise that money managers cant add value, but argue that they provide broader benefits for clients that help to justify their fees. These money managers argue that they help clients remain invested when the client might otherwise decide to sell, or help clients allocate capital to attractive areas of investment. So this group of asset managers would have us believe that active money management fees are justified as the price for providing ignorant or frightened clients with general investment advice. Ive heard brokers and money managers provide anecdotes for this proposition but have seen little in the way of hard data. Active money management fees are a steep price to pay for general investment advice.
Those managers who have moved into alternative investments, such as hedge funds and private equity, agree that traditional stocks and bonds are highly efficient. They concur that theres no reason to invest in active management in those areas. However, they claim that the ex-investment bankers and Wall Street traders who enter the alternative world are significantly smarter than their traditional brethren. As far as I can tell, they are only smarter in one important sense. Theyve come up with a better economic model. The fees and carried interest (profit sharing) are a much better deal for alternative managers than the flat fees charged by most traditional managers.
I dont blame active money managers for underperforming the market. Finding undervalued investment ideas on a consistent basis is extremely difficult. Securities that are mispriced arent clearly labeled. Whether a money manager does old-fashioned securities research or uses complicated computer models, the task of identifying attractive opportunities is fraught with error. When a manager finally unearths an investment gem, other investors quickly reach the same conclusion, and the opportunity disappears.
Rather, the blame lies with institutional investors who continue to allocate capital to managers who promise to give them more than the market can deliver. Money managers have compelling marketing pitches, and the folks running our pension plans, endowment and foundations are eager buyers. Of course, you and I are also to blame, because we continue to allocate our capital to active managers despite the evidence. Of course, were also inclined to buy lottery tickets and spend an evening or two in a casino. Just like lottery commercials and gaming advertisements, money management marketing is convincing. Combine an overly confident money manager with a compelling marketing message, and how can we resist?
Andrew Siltons Meditations on Money columns can be found twice a month in The N&Os Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/